With potentially thousands of dollars coming your way in the years ahead, you may need a strategy to get the most from your distributions.
Before you decide on any course of action in allocating your distributions, you should consult with a tax professional to make sure you’re making the best decisions based on your specific tax situation. If you expect to spend the money to cover retirement expenses, that’s probably an easy choice. Take the distribution, pay the taxes you owe, and use the money as needed. But if you are already receiving enough income to cover your bills through a job, Social Security, or any pension or investment income, it may help to develop a strategy for making the most of your distributions. Here are some options for doing just that:
Donate it. If you donate your distribution – or a portion of it – to a qualified charity, the amount of the distribution you donate is taxable, but may qualify as a tax deduction. (See: "Donor Advised Funds" Mix Charity, Investing and Flexibility)
Make a qualified charitable distribution (QCD). When you reach 70½, you can request up to $100,000 be sent directly to a qualified charity as a non-taxable distribution from your IRA. The QCD also counts towards your RMD for the year. But if you make deductible traditional IRA contributions and also request a QCD, the QCD amount will be reduced by the amount of the traditional IRA deductions.
Create an emergency fund. If you don’t already have an emergency fund, you may wish to use some of the after-tax distribution to set one up.
Fund your life insurance premiums. You may use RMDs to fund a life insurance policy. The policy could be used to defray the tax on your retirement assets that your family will receive. Or, you could name a charity as the beneficiary of your taxable retirement accounts, with your family being the beneficiary of your non-taxable life insurance.
Reinvest it. You may choose to invest your after-tax distribution in a mutual fund or other investment in an effort to keep it growing. There are a wide range of mutual funds available – the choice depends on your investment objectives. (See: Asset Allocation Funds Can Help Tame Volatility)
Start early and move some money to a Roth IRA. Even if you’re years away from turning 70, it may be helpful to plan ahead.
While you are not allowed to roll over your RMDs into a Roth IRA, you may be permitted to convert the remaining money within your retirement accounts to a Roth IRA. Keep in mind, however, that you would be required to pay taxes at your ordinary income rate on the money you convert in the year of the conversion.
After 5 years, and you’re 59½, disabled, first time home buyer ($10,000 limit) or the money is being paid to your beneficiary, all earnings can be withdrawn tax-free.
Having a source of tax-free income could give you more flexibility in controlling your tax liability in future years. (Note that access to converted dollars before age 59½ has restrictions.) (See: The Power of Pairing a Roth IRA with Your 401(k))
You can start the conversion process well before age 70 – and you can continue the conversions until you’ve emptied your tax-deferred account – as long as you don’t convert your RMDs. (See: Benefits of Roth IRAs Go Well Beyond Retirement)
Once your money is in a Roth IRA, you would no longer be required to take distributions during your lifetime. One of the key considerations is whether you can pay the taxes you will owe on the conversion from a separate source, rather than using your IRA assets to pay them. If you use IRA assets and you are under age 59½, you will owe the 10% early distribution tax on any funds not included in the amount converted to the Roth IRA.
Before making the decision to convert some or all of your tax-deferred account to a Roth IRA, you should carefully consider the tax consequences or speak with a tax professional to discuss the pros and cons. For instance, to help reduce the tax impact, you might consider spreading your conversions over several years – or waiting until you’re in a lower tax bracket in order to limit the tax burden.
But whether you withdraw the money now, or later when you’re required to take the annual distributions, you’re going to owe taxes at your ordinary income rate on all the money you withdraw. The decision you face is whether to take the hit sooner or later.